Page 1 - Proposed Regulations Provide Guidance on Deducting Fines and Penalties Paid to the Government: Important Questions Still Remain

COLUMNS I Tax Practice & Procedure

Proposed Regulations Provide Guidance on Deducting

Fines and Penalties Paid to the Government

Important Questions Still Remain

By Kevin M. Flynn

ince 1969, Internal Revenue Code (IRC) section The TCJA
162(f) has disallowed an ordinary and necessary The Tax Cuts and Jobs Act of 2017 (TCJA) amended
business deduction in computing taxable income IRC section 162(f) with the aim of ending the years of
for any civil or criminal fine or similar penalty controversy between taxpayers and the IRS regarding when
Spaid to a government or governmental entity for a fine or penalty paid to the government may be deducted.
the violation of a law [Public Law No. 91-172, 83 Stat. As amended, IRC section 162(f)(1) generally disallows a
487 (1969)]. This provision codified case law that denied a deduction for amounts paid or incurred to, or at the direction
taxpayer a business expense deduction for conduct that was of, a government, a governmental entity, or a nongovern-
considered by courts to frustrate well-defined national or mental entity with respect to the violation of a law or the
state public policies. Treasury Regulations promulgated by investigation into the potential violation of a law. Section
the U.S. Treasury Department and the IRS in 1975 modified 162(f)(2) provides exceptions to the general rule, and allows
this rule to provide that compensatory damages paid to the a taxpayer to deduct amounts that the taxpayer establishes
government did not constitute a fine or penalty. constitute restitution, including remediation of property, for
It is not surprising that disputes abounded between taxpay- damage or harm caused by the violation of any law, or are
ers and the IRS regarding what constituted a fine or penalty, paid to come into compliance with any law that was violated
or what constituted the payment of compensatory damages. or otherwise involved in the investigation. For payments to
Imprecise language and conflicting terms in criminal plea be deductible, IRC section 162(f)(2)(A)(ii) requires that the
agreements and civil settlement agreements between private amounts paid for restitution, remediation, or paid to come
litigants and the government often fueled these disputes. into compliance with the law must be identified in a court
order or settlement agreement.
The amounts deductible under IRC section 162(f)(2)
include amounts paid to the government as well as third par-
ties at the direction of the government. The amended statute
treats nongovernmental entities with self-regulatory powers
It is not surprising that disputes (including the imposition of sanctions), such as a national
securities exchange or domestic board of trade, as govern-
abounded between taxpayers mental entities. The TCJA included new IRC section 6050X,

and the IRS regarding what which imposes an information return reporting obligation
on certain governmental officials entering into settlement
constituted a fine or penalty, or agreements covered by IRC section 162(f).

what constituted the payment The Proposed Regulations
of compensatory damages. On May 13, 2020, the Treasury Department and IRS issued
proposed regulations under IRC section 162(f) and IRC
section 6050X. The proposed regulations and the accompa-
nying preamble provide guidance to taxpayers on the new
provisions under amended IRC section 162(f) and new IRC
section 6050X. They also respond to comments that Treasury
and the IRS received with respect to Notice 2018-23, issued
Taxpayers claimed business deductions for payments to on April 9, 2018, which provided transitional guidance under
the government that they maintained were compensatory or IRC section 162(f).
remedial in nature. When the IRS disallowed many of these The proposed regulations restate the general rule in IRC
deductions, litigation regarding the proper characterization section 162(f), and provide that a taxpayer may not take a
of the payments frequently ensued. deduction in computing taxable income for amounts paid

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